Larry Swedroe on the Problems of High US Equity Valuations

[walkinwood]

...and
How Advisors Can Factor In Current Evaluations Risks



Interesting article and worth reading.


Some of the more technical discussions went right over my head, but I understand the basic argument - that you cannot expect to get the long term average return when extrapolating from a very high market valuation.


https://www.kitces.com/blog/us-equity-valuations-investment-cape-10-diversification-stocks-sp-500/

 

[FI_RElater]

Karsten has focused on that issue for a long time in his ERN series:
https://earlyretirementnow.com/safe-withdrawal-rate-series/

There's a lot to look at there, and some can get quite technical; some might say he's a bit too conservative, but he goes into details especially for those having much longer likely retirement periods

 

[jebmke]

Surprised by his inclusion of private credit as a viable alternative. Many others seem to think that the marks in the PC market aren't good and a reckoning is coming. I suspect that PC is probably similar to PE or VC investments. A few large "insiders" or other major players will see that the rest of investors bear a disproportionate share of the pain.

 

[Dtail]

Surprised by his inclusion of private credit as a viable alternative. Many others seem to think that the marks in the PC market aren't good and a reckoning is coming. I suspect that PC is probably similar to PE or VC investments. A few large "insiders" or other major players will see that the rest of investors bear a disproportionate share of the pain.

Agree.
This is one of the main areas that small brokers like to point out how they can beat the overall ETF type funds.

 

[Dtail]

I read the article. Good conceptual points.
However I have a continuing issue with using a CAPE 10 valuation as very good correlation of future returns.
When was the last time that the CAPE 10 was at its historical average? Perhaps it was the time before its development as a tool itself. Even in March 2009, it was above the mean and median and has not been as low since, despite the market returns since 2009.

 

[Lewis Clark]

Karsten has focused on that issue for a long time in his ERN series:
https://earlyretirementnow.com/safe-withdrawal-rate-series/

There's a lot to look at there, and some can get quite technical; some might say he's a bit too conservative, but he goes into details especially for those having much longer likely retirement periods

To be fair, he focuses on safe withdrawal rates that have historically passed all back testing with very low failure rates. Concentrating on the worst case scenarios in the past will result in being conservative.

I find it comforting to understand the historical failsafe withdrawal rates even if I choose to use a higher withdrawal rate.

 

[LateToFIRE]

Surprised by his inclusion of private credit as a viable alternative. Many others seem to think that the marks in the PC market aren't good and a reckoning is coming. I suspect that PC is probably similar to PE or VC investments. A few large "insiders" or other major players will see that the rest of investors bear a disproportionate share of the pain.

You can add me to the list of folks who view the PC market as fairly high risk. These funds invest in the junkiest of junk - privately-owned, mid-market companies that cannot get loans through the institutional syndicated loan market, usually because the high leverage and credit ratings would be too scary for typical CLO's. We have not yet seen how PC portfolios would perform through a sustained trough - I suspect not well. That said, the yields are very attractive, so could be worth some limited exposure if you're a gamblin man/woman (i.e. optimistic on the U.S. economy next few years).

 

[jebmke]

You can add me to the list of folks who view the PC market as fairly high risk. These funds invest in the junkiest of junk - privately-owned, mid-market companies that cannot get loans through the institutional syndicated loan market, usually because the high leverage and credit ratings would be too scary for typical CLO's. We have not yet seen how PC portfolios would perform through a sustained trough - I suspect not well. That said, the yields are very attractive, so could be worth some limited exposure if you're a gamblin man/woman (i.e. optimistic on the U.S. economy next few years).

if the report I heard on Bloomberg is correct, it is also bigger than I imagined. They were kicking around a number like $1.5 T -- now you're talking some real money.

 

[FREE866]

Ugh...the whole " the CAPE is high" narrative....even the creator of this has been emphatic that this piece of data is NOT predictive of where stocks will go. Yet , for some reason it gets a huge following.



Anyone looking at the CAPE for the last ten years and has used it as reason to stay away from stocks has made a huge mistake. And does Larry Swedroe actually manage money?

 

[Dtail]

Ugh...the whole " the CAPE is high" narrative....even the creator of this has been emphatic that this piece of data is NOT predictive of where stocks will go. Yet , for some reason it gets a huge following.



Anyone looking at the CAPE for the last ten years and has used it as reason to stay away from stocks has made a huge mistake. And does Larry Swedroe actually manage money?

There you go.
I think it worked really well in hindsight until it was developed.

 

[walkinwood]

Karsten has focused on that issue for a long time in his ERN series:
https://earlyretirementnow.com/safe-withdrawal-rate-series/

There's a lot to look at there, and some can get quite technical; some might say he's a bit too conservative, but he goes into details especially for those having much longer likely retirement periods

I follow his posts regularly. Very rigorous in his research.

 

[FlaGator]

Ugh...the whole " the CAPE is high" narrative....even the creator of this has been emphatic that this piece of data is NOT predictive of where stocks will go. Yet , for some reason it gets a huge following.



Anyone looking at the CAPE for the last ten years and has used it as reason to stay away from stocks has made a huge mistake. And does Larry Swedroe actually manage money?

Well, he's done research for Buckingham since 1996, so not a rookie. https://www.buckinghamstrategicwealth.com/people/larry-swedroe I try to keep up with him. Don't always agree, but he's got enough miles to be worth listening to IMO.

 

[DrRoy]

The March 2 issue of The Economist has a similar article. I gave up any attempt to market time decades ago and have made much more for it.

 

[DJRR]

Maybe, or maybe the historical CAPE 10 is understated due to the fact that a large % of its data points to a time when you had to pay a broker, if you could get one, $80 per trade, could not buy odd lots, computers did not exist, no indexing, no 401k etc.

Seems to me that economic productivity boomed with computers, stock trading specifically became much more efficient, and demand for stocks has soared with indexing/self directed retirement. Corporate profits are at an all time high as a % of economic activity, so combined with increasing demand would justify a higher CAPE 10 in my mind. Or not, but not something I can control. He is making the same mistake by projecting past performance into the future, just taking the opposite side of the trade.

 

[sengsational]

There you go.
I think it worked really well in hindsight until it was developed.

If you dug through the very distant archives here you'd see that I once thought CAPE 10 had merit. Trying to put weight off of "this time it's different". But for the reasons listed in the previous post, I hate to say it, but "this time it IS different". Back then, I changed my AA to that of someone 20 years older. Well, now I'm 20 years older, no need to alter the AA... I'm already there.

 

[audreyh1]

I look at CAPE10 after 2000 to gage things and ignore the much lower previous decades.

 

[Running_Man]

https://static.fmgsuite.com/media/documents/bc618705-6161-4c00-be7f-c667c90c61b5.pdf

In January 2000 the Cape 10 was at 42. It had risen in a steady uptrend for over 18 years from a level of 6.62 in 1982. In 2000 no-one was worried about the CAPE 10 index, only in 2009 after the CAPE 10 fell back to 14 did conversations come around to the value of the CAPE 10.

The lows are 6.32 in 1932 and 7.4 in Aug 1982. The peaks are July 1932 32, October 1999 42 and now we are in another uptrend.

In 1939 the 10 year average return on the S&P500 from the peak was -3%,
In 2009 the 10 year average return on the S&P500 from the peak was -1%.

The 10 year returns off the bottom has been in excess of 12 % per year for about 4 years running so of course ignoring the CAPE10 appears to be the smart thing to do to anyone investing. In 1999 the 10 year average was in excess of 19% per annum and had surpassed the long term average of 10.32% for 15 straight 10 year rolling averages.

All appears to recommend that ignore the noise stay fully invested and don't mind anything and the more stocks the higher the return and adding bonds only reduces the long term average. You will be on the winning side almost 97% of the time. It's just that 3% of the time can be life altering.

 

[Out of Steam]

I look at CAPE10 after 2000 to gage things and ignore the much lower previous decades.

People farming for subsistence or working in neighborhood or village-level labor markets are not really a part of the larger money economy.

The number (and percentage) of people around the world who have enough income to support the broad market for goods and services has hugely increased since 2000. An example I heard yesterday from a neighbor was the substantial presence of KFC in Ghana.

While the words "It's different this time." are fraught with risk, sometimes fundamental changes do happen.

 

[RetMD21]

...and
How Advisors Can Factor In Current Evaluations Risks



Interesting article and worth reading.


Some of the more technical discussions went right over my head, but I understand the basic argument - that you cannot expect to get the long term average return when extrapolating from a very high market valuation.
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I skimmed it. I am still investing in value and international. The valuations continue to get better as the returns lag. I like that Larry is down to 4 horsemen it seems more traditional

 

[TickTock]

Ugh...the whole " the CAPE is high" narrative....even the creator of this has been emphatic that this piece of data is NOT predictive of where stocks will go. Yet , for some reason it gets a huge following.

Anyone looking at the CAPE for the last ten years and has used it as reason to stay away from stocks has made a huge mistake. And does Larry Swedroe actually manage money?

In reverse order:

As far as I can tell, Swedroe does not and has never run money. He does evidence-based investing research and has written several books on finance, also several articles in peer-reviewed journals. (My first encounter was with his book, The Only Guide to a Winning Investment Strategy You'll Ever Need, the original 1999 version IIRC.) Prior to that he was in banking.

You are correct that Shiller does not recommend CAPE10 for market timing. He does recommend it for use in AA and 'relative valuation exercises'.

In non-technical terms, there's been a strong run in equities since 2003. Generally the higher past returns have been over a decade or more, the lower they tend to be over the next decade or more. But no guarantee.

From the article, paragraph four: "...we need to review the evidence on the CAPE as a predictor of future returns. The key message is that while the CAPE 10 is the best predictor we have, explaining about 40% of future long-term equity returns, there is still a wide dispersion of potential outcomes – high valuations can go higher and low valuations can go lower."

I'm going through the 25-page 2018 paper linked to in paragraph five of the Kitces article. That'll take a while for me to digest.

 

[Running_Man]

People farming for subsistence or working in neighborhood or village-level labor markets are not really a part of the larger money economy.

The number (and percentage) of people around the world who have enough income to support the broad market for goods and services has hugely increased since 2000. An example I heard yesterday from a neighbor was the substantial presence of KFC in Ghana.

While the words "It's different this time." are fraught with risk, sometimes fundamental changes do happen.

The median salary in Ghana is $359 per month. GDP of the country is 63 billion about equal to about one month of Amazon's revenue, 1/3 of Jeff Bezo's net worth - 33 million people total have a country of 1/3 of what Jeff Bezo's owns. There are 33 KFC stores in Ghana

In 2000 the USA represented 30% of World GDP, today that has dropped but only to 25%. Major increase is China going from 4 percent to 18 percent. The rest of the world has actually shrunk as a percent of total world GDP.

However World GDP has gone from 30 Trillion to 100 trillion from 2000 - 5% nominal growth while the S&P500 has grown from 2,547 to 5,100 3% nominal growth in price. US GDP has gone from 10 Trillion to 23 Trillion a 3.5% nominal growth.

The remainder of the world has dropped from 66 percent of GDP to 60 percent of GDP 4.5% nominal GDP growth, below the growth of world GDP which is really just a story of China assuming a dominant role.

KFC has 33 outlets in Ghana the same number KFC had in China in 1997, today KFC has 22,000 outlets in Chinas selling 8 billion in sales, increasing at a 17% annual rate over the last 25 years. The rest of the world is negligible for the increase in sales as China accounts for almost all non-inflationary growth for KFC.

World Debt meanwhile over the same period grew at over 7% per year over the last 25 years.

 

[Out-to-Lunch]

It was once pointed out to me that PE is a ratio. And there are TWO ways that a ratio can change.

 

[RobLJ]

Off and on, I've read Swedlowe for about 20 years and, while I don't always agree with him, I've found him generally to be pretty level-headed. I think he tries to be pretty much fact based, although that means his writing is based in past data (Like FireCalc).


I had concerns in 1997 about S&P/large cap valuations and diversified. I turned out to be lucky in moving a bunch of gains to mid cap value. My "timing" was very lucky and you can't count on timing.
There is no rule that the Magnificent 7 returns can't continue to accumulate, but there are some warning signs, so I think the best thing about the article is the suggestion to diversify. I've done this since 2006, with international and smaller cap and many of you have run me in the ground. However, our portfolio did recover within about 10 months in 2001 and 15 months in 2009, so there is that. An S&P index portfolio no doubt would be ahead of ours, I suspect, by 2017 or so. The 2000 crash was a bit different, but like most of you I was just working and monthly contributing, which always works over time. I'll note that my Fidelity Contra is up more than 50% year over year, and that a good 35% of our portfolio is in it or large cap/S&P index, which has worked fantastically the last couple years. But not all of our money is there, the rest is bond funds, small/mid caps and international.Volatility is about half to 60% of the S&P but bonds and the international will swing that up or down.


Particularly if you aren't dependent on yearly withdrawals for retirement (unlike me), the S&P index is mighty hard to beat if you are thinking of your heirs or 20 years down the line. The good thing about diversification is that I can withdraw 1/2 or so from areas that have benefited, even if the S&P is down. So Jan/Feb when I do withdrawals is a bit easier. If you have enough of a stash and are withdrawing less than 3%, however, the S&P is a good way to go. We've been withdrawing 5.5-6.5%, so putting it all in the S&P seemed problematical. January I start claiming SS and the rate goes below 4% so whether it was luck or skill I'm no longer worried. I think we dodged the bullet. (Knock on wood).